Brokers are regulated and supervised by the Securities and Exchange Commission (SEC) and the Financial Industry Regulatory Authority (FINRA). Even still, doing your homework is the greatest way to avoid dishonest brokers. Despite this, even the most complete background check of the firm, broker, or planner isn’t always enough to protect investors from being duped.
Here, we look at some of the most shady tactics employed by brokers to maximize their commissions and push low-quality stocks onto naive customers.
Important Points to Remember
- If an unscrupulous broker churns accounts (trades frequently) to generate commissions for themselves, this is a red flag.
- Brokers who advocate investments below breakpoints in order to safeguard their commissions should also be avoided.
- Brokers have a responsibility to understand your financial needs (and limits) and offer appropriate investment recommendations based on that knowledge.
Churning is the practice of trading a client’s account excessively. This unethical practice is used by some brokers with discretionary authority over an account to raise their compensation. Churning is done to benefit the broker rather than the investor, because the primary goal of the deal is to raise commissions, not to grow the wealth of the customer.
In fact, if a deal has no genuine aim, it can be deemed churning. An extraordinary spike in transactions without any gains in a portfolio’s value could be an indication of churning.
Consider a wrap account if you’re concerned about your account being churned. This is a type of account in which a broker manages a portfolio for a fixed fee. A wrap’s benefit is that it prevents you from overtrading. Because the broker is paid a single annual fee, they will only trade when it is in your best interests.
Even if you’ve given your broker permission to trade on your behalf, it’s always a good idea to keep track of what’s going on with your portfolio.
2. Dividends are sold
Dividend selling occurs when a broker tries to persuade a customer that acquiring a specific investment, such as stocks or mutual funds, would be profitable due to an upcoming dividend. In actuality, the broker is attempting to earn commissions by selling a client for a rapid profit.
Consider the case of a $50-per-share corporation that is set to pay a $2.50-per-share annual dividend. If a broker advised a customer to buy the shares immediately for a 5% return, they would be “selling dividends.” In reality, the client will not make this payment.
When the stock becomes ex-dividend, the price will drop by $2.50 (the dividend). In other words, the investor makes very little money in the short run. In addition, the transaction may result in a tax burden for the investor.
This strategy is also used in mutual funds: an advisor will advise a customer to acquire a fund since the companies in the fund pay out dividends. The mutual fund’s net asset value is discounted by the value of the dividend, just as the stock price above, resulting in a gain only for the broker—in the form of commissions. In reality, the investor would be better off waiting until after the dividend offer because the stock will be cheaper and the dividend income will be taxed at a reduced rate.
3. Withholding Investment Recommendation at Breakpoint
Certain investments are subject to a sales charge at several brokerages and mutual fund firms. These sales costs aren’t necessarily unlawful, but they can lead to investors paying more than they should.
Let’s imagine a mutual fund charges 5% on investments under $25,000 but just 4% on investments of $25,000 or above. If you invest $25,000, you will experience a breakpoint sale because your investment is in a lower sales-charge range.
Unscrupulous advisors, on the other hand, may advise you to put $24,750 in the fund despite the fact that investing $25,000 would save you $250 in sales charges, or 1%. Advisors may also prevent you from benefiting from breakpoints by dividing your money among multiple investing firms, even if they all provide equivalent services.
As a result, the advisor earns more commissions and you save less money because you can’t take advantage of the reduced commission rates once you hit the higher breakpoints.
4. Inappropriate Transactions
To summarize the nature of all of these practices, we’d like to highlight the word “unsuitable transactions,” which refers to investments made in a way that is inconsistent with the client’s circumstances or investment goals. You should be aware that your broker has a legal obligation to understand your financial needs (and limits) and to offer investment suggestions based on that knowledge. 1
Double tax exemptions are an example of an improper transaction. The way they work is that an investment advisor invests money that is already tax-free, such as money in an IRA, in tax-free bonds or other securities. This is usually not a good idea because the investor does not require a tax-free investment and such investments typically do not yield as much as other options. The transaction is inappropriate since it does not meet the needs of the client.
Other deals that could be considered improper are:
- If you have a poor risk tolerance, you should avoid high-risk investments.
- Investing a large portion of your money in a single stock or asset.
- Those who require quick access to capital should invest in illiquid assets.
Maintaining focus on one’s accounts is critical for all investors, regardless of their financial circumstances. This does not imply that you should check your account every day, but you should do it on a frequent basis to keep up with what’s going on. Most sorts of broker fraud can be avoided if this is done in conjunction with a comprehensive analysis of a broker’s investment ideas.